Barron’s has one of their by now regular articles on MLPs this weekend as they interview their “MLP Roundtable”. These write-ups are invariably constructive, and the most recent one is no exception. As well as noting the many opportunities offered to build out infrastructure in support of America’s shale boom, General Partners (GPs) received a mention. Roundtable member Douglas Rachlin of Neuberger Berman pointed out that, “GPs are not required to contribute capital to the organic-growth projects or acquisitions their MLPs make; yet they benefit in a disproportionate manner through their ownership of distribution rights.”

Becca Followill of U.S. Capital Advisors added, “Some MLPs don’t have a general partner, which makes them easier to take out and can make a deal more accretive more quickly.”

These are both features of MLPs that we’ve long identified and reflected in our own MLP strategy.

Quite a few names reported quarterly earnings last week. The numbers were generally good and MLPs are overwhelmingly reporting increases in future capital investment which for GPs at a minimum assures continued growth in distributed cashflow received and therefore in dividends paid. But not everything was good. Buckeye Partners (BPL) issued a surprisingly disappointing report which included losses in their Merchant Services division. We’re investors in BPL and have been for years.

The most attractive businesses for MLPs are fee-based whereby they earn recurring income from storage and pipeline assets. BPL largely does this, but like a handful of other MLPs they also have a marketing division which incurs basis risk on its underlying products on behalf of customers, often in exchange for quite narrow margins.

These activities can be quite tricky to manage. MLPs face a principal-agent problem here, in that their desire is to generate a return through using their inside knowledge and control of product to charge more than the cost of the basis risk incurred. However, there is inevitably judgment involved, and while the MLP wants to exploit an additional element of its franchise, if not properly managed the traders involved will seek to make money from the risk taking side of this. In fact, risk-averse basis trading maximizes the firm’s franchise value and minimizes the value added of the trader. The trader’s incentive can therefore be to minimize the apparent value of the franchise so as to maximize the apparent value of his skill-based activities. It can lead to excessive risk-taking, since profits from properly exploiting the MLP’s position in the middle of all kinds of information about supply and demand can appear to value the trader less than trading profits generated through his own skill/judgment.

It’s not only banks that can get themselves into trouble with risk. And in BPL’s case, it appears that a poorly constructed hedging strategy went wrong during the 2Q, causing the Merchant Services unit to swing to an operating loss.

Positions were liquidated, people fired and a more modest business model adopted. But it shows that unwelcome surprises can come from units that appear to offer steady if unspectacular returns, if the principal-agent conflict described isn’t carefully managed.

Interesting perspective on where the IRS is likely to focus from Robert Willens in Barrons today. He notes, “While the IRS is getting more restrictive on REITs and inversions, they are getting more expansive on MLPs, for some unknown reason. They are allowing a broader class of entity to convert to MLP status.”

On Saturday, Barron’s ran a front cover piece that was negative on Kinder Morgan (“Yield of Dreams”). Andrew Bary has written many thoughtful pieces for Barron’s over the years. In this case he basically reproduced a negative report written by Hedgeye’s Kevin Kaiser from last year. Kinder Morgan Inc (KMI) was down yesterday because evidently some readers of Barron’s haven’t heard of Kevin Kaiser.

The issue Kaiser raises is whether Kinder Morgan Partners (KMP) and El Paso (EPB) skimp on maintenance in order to increase their Distributable Cash Flow (DCF) of which close to 50% goes to the General Partner, KMI. We like KMI for this reason as we’ve noted before. They benefit from increased assets and cashflows at KMP and EPB without having to put up any capital. Rich Kinder does too, since he owns $8BN of the stock.

As for whether they do skimp on maintenance cap ex or not, the evidence would seem to suggest they don’t. Kinder Morgan’s safety record is at least as good as their peers; their return on invested capital has been consistent and above their cost of capital; their leverage ratios have also remained stable.  From these perspectives, we feel comfortable with their management of these assets. As the development of shale oil and gas creates the need for investments in energy infrastructure, Kinder Morgan will be a significant player (they have a current project backlog of $14BN against an enterprise value of about $100BN). KMI should see growth in cashflows from the increased DCF at the MLPs it controls. Its forward dividend yield is 5%, and expected to grow at 8% over the next several years. Kinder Morgan issued a response to the Barron’s article yesterday.

No doubt KMI has performed poorly in recent months, partly because they lowered their forecast dividend growth from 9-10% last year but also due to negative sentiment caused by Hedgeye’s analysis. We continue to think it’s an attractive investment at current levels.

Last week an investor in Kinder Morgan Partners (KMP) filed a lawsuit against its general partner, Kinder Morgan Inc. (KMI), alleging that KMI (which runs KMP) had directed excessive cash distributions to itself to the detriment of investors in KMP. The suit (filed by Jon Slotoroff) highlights a seldom noted feature of MLPs, which is that investors have far less power than conventional equity investors in a corporation. MLP GPs are extremely hard to displace, enjoy preferential rights with respect to distributable cashflow (DCF) and can organize the capital structure of their MLP in such a way as to benefit the GP at the expense of the MLP unit holders (by, for example, causing the MLP to issue dilutive equity that increases distributions to the GP).

These features are disclosed to those who read the documents. KMP’s 2013 10-K for example notes in its Risk Factors that, “The general partner can protect itself against dilution”, that conflicts of interest of the GP may be resolved in ways that are unfavorable to LP unitholders and various other issues of control. Removing KMI as the GP takes a two thirds vote of the LPs but no one holder may vote more than 20% of the units even if they own more.

Simply put, the value proposition for an MLP is for its GP to manage its distribution yield and capital structure such that it’s just sufficient to maintain demand for new units as they’re sold but not overly generous. Too much abuse of LPs will drive up the required yield to sell additional equity, impeding the GPs ability to continue growing the MLP and the DCF it receives. But there’s little point in running an MLP to be overly generous to its unitholders, unless the GP also owns healthy percentage of the MLP’s units (and some do).

Suing KMI under such circumstances seems to be a waste of time, although America is a litigious country and any lawyer will tell you that in court anything can happen. But the fact of the lawsuit highlights the stronger position of GPs versus LPs in the MLP structure. The sensible move would seem to be to invest in GPs and therefore avoid the need to sue as a disgruntled LP. Evidently, not everybody reads the SEC filings before they invest.

So far we’re half way through Kinder Morgan’s analyst day. It opened with a summary by Rich Kinder who repeated his oft-stated thoughts that the stock price of all four Kinder entities is too low. We agree with him at least in the case of Kinder Morgan Inc (KMI) which we own. We much prefer the position of General Partner over Limited Partner, although so far the presentations haven’t been able to draw in too many new buyers of the stock, with KMI currently -3.4%. Everything we’ve heard is consistent with a solid long term growth story in U.S. energy infrastructure. Kinder Morgan (KM) is involved in numerous ways, and the development of shale resources is causing many new opportunities and incongruous developments that the company is involved in. These include:

1) Increased capability to export coal, since domestic demand is being displaced by natural gas. In spite of the developed world’s focus on clean energy, coal use is forecast to exceed crude oil in consumption by 2020, on an energy-equivalent basis.

2) Regulatory uncertainty over the Keystone pipeline as well as the increasing variability of liquids produced is increasing the need for flexible supply systems. Crude by rail has grown enormously, to the benefit of firms like Burlington Northern (owned by Berkshire Hathaway, BRK, another holding of ours). KM is investing in infrastructure to support more movement of crude oil by rail.

3) Distillate is being transported from the Marcellus shale in Pennsylvania to the Canadian tar sands in Alberta, where it is used as a diluent mixed in with the heavy crude produced there to ease its subsequent transportation.

There were many projects aimed at increasing existing pipeline capacity, reversing pipelines and creating additional infrastructure to move  product from where it’s produced to refiners and end users.

So far a very interesting session, with no doubt more to come.